What Is Still Missing from the Banking Union

FISCAL BACKSTOPS TO ADDRESS EXTREME FINANCIAL NEEDS THAT ARISE BECAUSE OF A SYSTEMIC CRISIS ARE NOT YET IN PLACE. GUARANTEES TO BANKS ARE HARD TO CALIBRATE, AS BOTH LENIENCY AND RESTRICTIVENESS HAVE RISKS, BUT AN EMERGENCY PLAN SHOULD EXIST

by Elena Carletti, Dept. of Finance, Bocconi
Translated by Alex Foti

The Banking Union is an epoch-making historical change, comparable to the introduction of the euro back in 1999. Next to the Single Supervisory Mechanism, it also contains a crisis-resolution mechanism, with its own Single Resolution Fund, and a harmonized (but not common yet) scheme for the European guarantee of national deposits.

 

Yet something seems to be still missing. In spite of the strong political effort made in this direction, the Banking Union does not provide at the moment for true contingent forms of financing, the so-called fiscal backstops.  This would entail the creation of EU-wide public credit lines to be activated in case of financial emergency, in order to stave off sovereign debt crises or fulfill major recapitalization needs by banks. Such an absence has significant consequences for a number of reasons.

 

Firstly, without a direct European credit line for each individual financial institution, there could be a repetition of what happened a few years ago, when national governments found themselves suddenly responsible for the actions of financial markets that had vastly outgrown them and gone beyond their fiscal reach. If a financial crisis re-occurred, it would mean that the banking union has failed to meet one of its stated main objectives, notably breaking the vicious circle linking banks to debts of national governments.

 

Secondly, since an end game is lacking – i.e. there is uncertainty about what would happen in the event of a new systemic crisis, when the resources of the various funds that have been established, such as the Stability Mechanism or the Resolution Fund, could dwindle very quickly – the whole decision-making process could be undermined and the incentives for the various actors that are part of the Banking Union seriously biased.

 

It is well known that there is a moral hazard problem, when guarantees of solvency and liquidity are given to banks, because their managers could be encouraged to take on risky financial positions. But it’s also a fact that any form of government-backed financial guarantee must be clear and credible, in order to avoid panic situations and financial contagion among intermediaries. If such a guarantee is lacking, there is the risk is that politicymakers monitoring and regulating financial markets could take either excessively restrictive or excessively permissive decisions, in the attempt to bring down systemic risk.

 

Both biases lead to inefficient outcomes. Excessive stringency could hamper the supply of credit by banks, while excessive forbearance could lead financial intermediaries to take even riskier bets.

 

It may well be that it was because of the lack of fiscal backstops that, overall, the recent comprehensive assessment gave passing grades to the eurozone’s banking system. Perhaps the Banking Union should not be submitted to such a trying test so early in its institutional life. On the other hand, one wonders if the absence of genuine guarantees of last resort is questioning the very rationale of the whole project.